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Death benefits are generally issued tax-free
Incremental payouts and employer-provided group life insurance may be taxed
You should speak to a licensed financial advisor about the tax implications of your life insurance policy
Life insurance is one of the best ways to build a financial safety net. It provides money to beneficiaries to pay for things like college, a mortgage and more. But most large sums of money, like lottery winnings, are subject to tax.
So are life insurance proceeds taxable? Usually not, but some scenarios do allow for the death benefit to be taxed.
In this article:
This article is concerned with what is taxable when it comes to life insurance and what isn’t. That’s determined by specific sections of the U.S. tax code. Together, these codes create guidelines on what falls under life insurance tax rules and what don’t.
U.S. Code, Title 26, Subtitle A, Chapter 1, Subchapter B, Part III, § 101 - Certain death benefits — This section discusses benefits received by “reason of death.” It sets the groundwork for the circumstances under which someone receives life insurance benefits, including accelerated death benefits — benefits from an insured who hasn’t died but is terminally ill.
U.S. Code, Title 26, Subtitle F, Chapter 79, § 7702 – Life insurance contract defined — In short, this section answers the question, “what is life insurance?”
U.S. Code, Title 26, Subtitle A, Chapter 1, Subchapter L, Part I, Subpart B, § 803 - Life insurance gross income — This section notes that dividends are not taxable — something that’s important in permanent cash-value life insurance policies.
It’s not required for a shopper to know the ins and outs of the entire U.S. tax code; a financial adviser can help you navigate the details and determine exactly what is and isn’t taxable.
Because a life insurance death benefit usually isn’t considered taxable income, income tax usually doesn’t apply. However, the three types of taxes that policyholders and beneficiaries should be most aware of are estate taxes, gift taxes, and the generation-skipping transfer tax.
Estate tax — The federal estate tax applies to high-value estates. As of 2020, the current estate tax threshold is $11.58 million, up from $11.4 million in 2019. Any amount of your estate over the estate tax threshold is subject to taxation. In addition to the federal estate tax, states can also have their own estate or inheritance tax. Estate taxes are set against the estate, while an inheritance tax is levied on transferred assets.
Gift tax — A federal tax on assets given as gifts. The gift tax is in place to prevent people from avoiding taxes by “gifting” money rather than it being included in an estate. This most often comes into play when the policyholder is still alive and transfers a policy to a beneficiary. There is a lifetime exemption that is the same as the estate tax as well as an annual exemption ($15,000 as of 2020).
Generation-skipping transfer tax — As the name implies, this applies to assets that skip a generation (for instance, a grandparent leaving property to a grandchild). It has the same exemption limits as the estate tax.
These taxes will not apply in every situation, and most people will be exempt from them due to their high limits. But they’re important to keep in mind, as they’re each a valuable component of estate planning.
In general, life insurance proceeds are not subject to taxation. The money is typically disbursed tax-free to any beneficiaries. However, there are some instances when taxes come into play; they include circumstances involving incremental payouts, estate size, cash-value policies, selling a policy, and group life insurance.
A life insurance death benefit is most often doled out as one lump sum of money. However, a beneficiary can choose to receive it in incremental payouts. This can be helpful for someone who isn’t particularly financially responsible; monthly installments better replicate a lost income stream and can be easier to handle than one lump sum of tens of thousands of dollars.
However, if a beneficiary elects to go with an installment plan for the life insurance payout, the total death benefit will accrue interest over the years. The beneficiary won’t be taxed on the benefit, but may be taxed on the interest gained. This is an important extra cost to be mindful of, and an argument for taking the death benefit as a lump sum.
If the addition of the death benefit causes your assets to exceed the estate tax threshold, your estate may be subject to taxation. One way to avoid this is to use an irrevocable life insurance trust (ILIT) so the death benefit is not counted as part of your estate. The trust disburses the death benefit to your beneficiaries. Additionally, you may gift a life insurance policy you already have to the ILIT, but if the policy hasn’t been part of the ILIT for more than three years when you die, then the death benefit will still be included in the estate.
One key term to know when it comes to irrevocable life insurance trusts is Crummey powers, which is essentially a way to pass assets to beneficiaries free of the gift or estate tax, making it completely tax-exempt. It may be more complex than most people need, but a financial adviser can help implement it if necessary.
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Term life insurance policies are straightforward in that there’s only a death benefit to deal with. But permanent policies like whole life insurance are more complicated because they come with an investment-like cash-value component.
Cash-value policies can pay out dividends. These are called participating policies. In contrast, non-participating policies do not pay out dividends (term insurance is an example of this; there are, less commonly, non-participating whole life insurance). Dividend payments are not taxable, as stated in the U.S. tax code.
The cash value of a policy can increase over the years (or decrease), but usually a whole life insurer offers a guaranteed minimum interest. Cash value gains are tax-deferred. Withdrawals less than or equal to what you’ve paid into the policy, known as the cash basis, are not taxable. However, withdrawals greater than the cash basis are taxable.
Additionally, policyholders can borrow against the cash value, essentially taking out a loan. Any unpaid loans (for example, if the policy lapses) are taxable.
Whole life policyholders can also surrender a policy for a cash amount. If there’s any profit made from the surrender, it’s subject to taxation.
Some employers offer group life insurance as a workplace benefit. This usually isn’t a substitute for an individual policy because the coverage isn’t very high. The coverage amount also plays a role in taxation.
If you get life insurance coverage through your work and your employer is subsidizing the cost, any coverage over $50,000 is treated as income and you’ll be taxed accordingly. Any amount under $50,000 is not taxed.
It’s possible to sell the rights of a life insurance policy to a third party. Similar to surrendering a cash value policy, if you sell a policy and make any profit off of it, that profit will be taxed as earned income.
Life insurance premiums are not tax-deductible. Even if you are a freelancer paying for your own policy because you don’t have access to an employer policy, you cannot deduct premium payments from your taxes. Policyholders also can’t use a flexible spending account or health savings account to pay life insurance premiums.
Return of premium life insurance life insurance policies do just what they say: When the policy is up, the premiums paid over the previous decades are returned to the policyholder.
Getting a large lump sum of money usually incurs taxes — think lotto winnings, for example.
But a return of premium is tax-free. That’s because it’s literally just a refund — your money gets returned to you — and not a payment. It’s refunded more or less in the same amount as it was 10, 20 or 30 years previous (minus any potential fees).
But that’s both a pro and con of return of premium life insurance. You don’t have to pay taxes on the money returned, but you’ve also been paying much more than you would for a traditional policy — usually about 30% more than a comparable standard term policy. Plus, you will have missed out on decades worth of interest by investing the difference. Investing $50 more a month over 30 years, including compounding interest, adds up.
Learn more about if return of premium life insurance is worth it.
It’s important to never make assumptions about which life insurance proceeds are taxable and which aren’t, as every financial situation is different. Always speak to a financial adviser about your estate plans to ensure your beneficiaries are not saddled with undue burden.
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